Chapter
13

What is a Competitive Market?
• The meaning of competition
• Competitive market
– Market with many buyers and sellers
– Trading identical products
– Each buyer and seller is a price taker
– Firms can freely enter or exit the market
2

What is a Competitive Market?
• The revenue of a competitive firm
– Maximize profit
• Total revenue minus total cost
• Total revenue = price times quantity = P ˣ Q
– Proportional to the amount of output
• Average revenue
– Total revenue divided by the quantity sold
3

What is a Competitive Market?
• The revenue of a competitive firm
• Marginal revenue
– Change in total revenue from an additional unit sold
• For competitive firms
– Average revenue = P
– Marginal revenue = P
4

Table 1
Total, average, & marginal revenue - competitive firm
Quantity
(Q)
1 gallon
2
3
4
5
6
7
8
Price
(P)
6
6
6
6
$6
6
6
6
Total revenue
(TR=P ˣ Q)
30
36
42
48
$6
12
18
24
Average revenue
(AR=TR/Q)
6
6
6
6
$6
6
6
6
Marginal revenue
(MR= Δ TR/ Δ Q)
$6
6
6
6
6
6
6
5

Profit Maximization& Competitive Firm’s Supply Curve
• A simple example of profit maximization
• Maximize profit
– Produce quantity where total revenue minus total cost is greatest
– Compare marginal revenue with marginal cost
• If MR > MC – increase production
• If MR < MC – decrease production
6

Table 2
Profit maximization: A numerical example
Quantity
(Q)
0 gallons
1
2
3
4
5
6
7
8
Total revenue
(TR)
$0
6
12
18
24
30
36
42
48
Total cost
(TC)
$3
5
8
12
17
23
30
38
47
Profit
(TR-TC)
-$3
1
4
6
7
7
6
4
1
Marginal
Revenue
(MR= Δ TR/ Δ Q)
Marginal
Cost
(MC= Δ TC/ Δ Q)
Change in profit
(MR-MC)
$6
6
6
6
6
6
6
6
$2
3
4
5
6
7
8
9
$4
3
2
1
0
-1
-2
-3
7

Profit Maximization& Competitive Firm’s Supply Curve
• The marginal-cost curve and the firm’s supply decision
– MC curve – upward sloping
– ATC curve – U-shaped
– MC curve crosses the ATC curve at the minimum of ATC curve
– P = AR = MR
8

Profit Maximization& Competitive Firm’s Supply Curve
• The marginal-cost curve and the firm’s supply decision
• Three general rules for profit maximization:
– If MR > MC - firm should increase output
– If MC > MR - firm should decrease output
– If MR = MC - profit-maximizing level of output
9

Figure 1
Profit maximization for a competitive firm
Costs and
Revenue
The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue.
MC
2
MC
ATC
P=MR
1
=MR
2
AVC
P=AR=MR
MC
1
0 Q
1
Q
MAX
Q
2
Quantity
This figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC), and the average-variable-cost curve (AVC). It also shows the market price (P), which equals marginal revenue (MR) and average revenue (AR). At the quantity Q
1
, marginal revenue MR
1 exceeds marginal cost MC
1
, so raising production increases profit. At the quantity Q
2
, marginal cost MC
2 is above marginal revenue MR
2
, so reducing production increases profit. The profit-maximizing quantity Q
MAX is found where the horizontal price line intersects the marginal-cost curve.
10

Profit Maximization& Competitive Firm’s Supply Curve
• The marginal-cost curve and the firm’s supply decision
• Marginal-cost curve
– Determines the quantity of the good the firm is willing to supply at any price
– Is the supply curve
11

Figure 2
Marginal cost as the competitive firm’s supply curve
Price
MC
P
2
P
1
ATC
AVC
0 Q
1
Q
2
Quantity
An increase in the price from P
1 to P
2 leads to an increase in the firm’s profit-maximizing quantity from Q
1 to Q
2
. Because the marginal-cost curve shows the quantity supplied by the firm at any given price, it is the firm’s supply curve.
12

Profit Maximization& Competitive Firm’s Supply Curve
• Shutdown
– Short-run decision not to produce anything
• During a specific period of time
• Because of current market conditions
– Firm still has to pay fixed costs
• Exit
– Long-run decision to leave the market
– Firm doesn’t have to pay any costs
13

Profit Maximization& Competitive Firm’s Supply Curve
• The firm’s short-run decision to shut down
– TR = total revenue
– VC = variable costs
• Firm’s decision:
– Shut down if TR<VC (P<AVC)
• Competitive firm’s short-run supply curve
– The portion of its marginal-cost curve
– That lies above average variable cost
14

Figure 3
The competitive firm’s short-run supply curve
Costs
1. In the short run, the firm produces on the
MC curve if P>AVC,...
MC
ATC
AVC
2. ...but
shuts down if P<AVC.
0 Quantity
In the short run, the competitive firm’s supply curve is its marginal-cost curve (MC) above average variable cost (AVC). If the price falls below average variable cost, the firm is better off shutting down.
15

Profit Maximization& Competitive Firm’s Supply Curve
• Spilt milk and other sunk costs
• Sunk cost
– Has already been committed
– Cannot be recovered
– Ignore them when making decisions
16

Near-empty restaurants and off-season miniature golf
• Restaurant – stay open for lunch?
– Fixed costs
• Not relevant
• Are sunk costs in short run
– Variable costs – relevant
– Shut down if revenue from lunch < variable costs
– Stay open if revenue from lunch > variable costs
• Operator of a miniature-golf course
– Ignore fixed costs
– Stay open if revenue > variable costs
17

Profit Maximization& Competitive Firm’s Supply Curve
• Firm’s long-run decision to exit/enter a market
– Exit the market if
• Total revenue < total costs; TR < TC
• Same as: P < ATC
– Enter the market if
• Total revenue > total costs; TR > TC
• Same as: P > ATC
• Competitive firm’s long-run supply curve
– The portion of its marginal-cost curve
– That lies above average total cost
18

Figure 4
The competitive firm’s long-run supply curve
Costs
1. In the long run, the firm produces on the
MC curve if P>ATC,...
MC
ATC
2. ...but
exits if
P<ATC
0 Quantity
In the long run, the competitive firm’s supply curve is its marginal-cost curve (MC) above average total cost (ATC). If the price falls below average total cost, the firm is better off exiting the market.
19

Profit Maximization& Competitive Firm’s Supply Curve
• Measuring profit
– If P > ATC
• Profit = TR – TC = (P – ATC) ˣ Q
– If P < ATC
• Loss = TC - TR = (ATC – P) ˣ Q
• = Negative profit
20

Figure 5
Price
Profit as the area between price and average total cost
(a) A firm with profits (b) A firm with losses
MC
Price
MC
Profit
P
ATC
ATC
P=AR=MR
ATC
P
Loss
ATC
P=AR=MR
0 Q Quantity
(profit-maximizing quantity)
0 Q
(loss-minimizing quantity)
Quantity
The area of the shaded box between price and average total cost represents the firm’s profit.
The height of this box is price minus average total cost (P – ATC), and the width of the box is the quantity of output (Q). In panel (a), price is above average total cost, so the firm has positive profit. In panel (b), price is less than average total cost, so the firm has losses.
21

Supply Curve in a Competitive Market
• Short run: market supply with a fixed number of firms
– Short run – number of firms is fixed
– Each firm – supplies quantity where P = MC
• For P > AVC: supply curve is MC curve
– Market supply
• Add up quantity supplied by each firm
22

Figure 6
Short-run market supply
(a) Individual firm supply
Price
MC
Price
$2.00
1.00
$2.00
1.00
(b) Market supply
Supply
0 100 200 Quantity
(firm)
0 100,000 200,000 Quantity
(market)
In the short run, the number of firms in the market is fixed. As a result, the market supply curve, shown in panel (b), reflects the individual firms’ marginal-cost curves, shown in panel (a). Here, in a market of 1,000 firms, the quantity of output supplied to the market is 1,000 times the quantity supplied by each firm.
23

Supply Curve in a Competitive Market
• Long run: market supply with entry and exit
• Long run – firms can enter and exit the market
– If P > ATC – firms make positive profit
– New firms enter the market
– If P < ATC – firms make negative profit
– Firms exit the market
– Process of entry and exit ends when
– Firms still in market: zero economic profit (P = ATC)
– Because MC = ATC: Efficient scale
– Long run supply curve – perfectly elastic
• Horizontal at minimum ATC
24

Figure 7
Long-run market supply
(a) Firm’s Zero-Profit Condition
Price
MC
ATC
Price
P= minimum
ATC
(b) Market supply
Supply
0 Quantity
(firm)
0 Quantity
(market)
In the long run, firms will enter or exit the market until profit is driven to zero. As a result, price equals the minimum of average total cost, as shown in panel (a). The number of firms adjusts to ensure that all demand is satisfied at this price. The long-run market supply curve is horizontal at this price, as shown in panel (b).
25

Supply Curve in a Competitive Market
• Why do competitive firms stay in business if they make zero profit?
– Profit = total revenue – total cost
– Total cost – includes all opportunity costs
– Zero-profit equilibrium
• Economic profit is zero
• Accounting profit is positive
26

Supply Curve in a Competitive Market
• A shift in demand in the short run & long run
• Market – in long run equilibrium
– P = minimum ATC
– Zero economic profit
• Increase in demand
– Demand curve – shifts outward
– Short run
• Higher quantity
• Higher price: P > ATC – positive economic profit
27

Supply Curve in a Competitive Market
• A shift in demand in the short run & long run
• Because: positive economic profit in short run
• Long run – firms enter the market
– Short run supply curve – shifts right
– Price – decreases back to minimum ATC
– Quantity – increases
• Because there are more firms in the market
– Efficient scale
28

Figure 8
Price
An increase in demand in short run and long run (a)
(a) Initial Condition
Market Firm
Price
1. A market begins in longrun equilibrium…
Short-run supply, S
1
2. …with the firm earning zero profit.
MC
ATC
A
P
1
Long-run supply
P
1
0 Q
1
Demand, D
1
Quantity
(market)
0 Quantity
(firm)
The market starts in a long-run equilibrium, shown as point A in panel (a). In this equilibrium, each firm makes zero profit, and the price equals the minimum average total cost.
29

Figure 8
Price
An increase in demand in short run and long run (b)
(b) Short-Run Response
Market Firm
Price
P
2
P
1
3. But then an increase in demand raises the price…
S
1
B
A
Long-run supply
P
2
P
1
4. …leading to short-run profits.
MC
ATC
D
1
D
2
0 Q
1
Q
2
Quantity
(market)
0 Quantity
(firm)
Panel (b) shows what happens in the short run when demand rises from D
1 goes from point A to point B, price rises from P
1 to D
2
. The equilibrium to P
2
, and the quantity sold in the market rises from Q
1 to Q
2
. Because price now exceeds average total cost, firms make profits, which over time encourage new firms to enter the market
30

Figure 8
Price
An increase in demand in short run and long run (c)
(c) Long-Run Response
Market Firm
Price
6. …restoring longrun equilibrium.
P
2
P
1
5. When profits induce entry, supply increases and the price falls,…
S
1
S
2
B
A C
Long-run supply
P
1
MC
ATC
D
1
D
2
0 Q
1
Q
2
Q
3
Quantity
(market)
0 Quantity
(firm)
This entry shifts the short-run supply curve to the right from S new long-run equilibrium, point C, price has returned to P
1
1 to S
2
, as shown in panel (c). In the but the quantity sold has increased to
Q
3
. Profits are again zero, price is back to the minimum of average total cost, but the market has more firms to satisfy the greater demand.
31

Supply Curve in a Competitive Market
• Why the long-run supply curve might slope upward
– Some resource used in production may be available only in limited quantities
• Increase in quantity supplied – increase in costs – increase in price
– Firms may have different costs
• Some firms earn profit even in the long run
• Long-run supply curve
– More elastic than short-run supply curve
32